Understanding the Commodities Markets

In the mid 1800s, Midwest farmers would meet in the middle of Chicago and try to sell the crops that they just harvested to willing buyers. As time went by, some would try to sell these crops before the crops were actually in. The commodities futures market evolved when these farmers began to commit to future exchanges of grain for future payments of cash.

For instance, a farmer would agree with a buyer on a price to deliver to him 5,000 bushels of wheat at the end of June. If the price suited both parties, they would enter into a “futures contract” (they didn’t call it at that time, but that was what it was). The farmer knew how much he would be paid for his wheat, and the buyer knew how much this wheat would cost him.

Thus was born the “commodities” market. As these contracts became more and more common, documents representing these contracts began to be exchanged. If a farmer needed money before the contract was “due”, he could use this contract as collateral and pay the loan back when he received the proceeds for his eventual sale of wheat. Conversely, if the buyer decided he didn’t want the wheat, he could sell the contract to someone who did. The farmer could also decide not to deliver his wheat and pass this obligation on to another farmer. The price of wheat would continue to go up and down, depending on what was happening in agricultural markets.

Bad weather may mean that those who contracted to sell wheat would have wheat contracts that were more valuable because the supply would be lower. However, if there was a boom harvest, a seller’s contract would become less valuable because there was so much wheat around. After a while, speculation came into the picture and investors who had never planned on ever buying or selling wheat would trade these wheat “contracts”, betting on whether the price of wheat would go up or down.

From this beginning, many commodities started to be traded. Today, each of the largest traded agricultural products has a commodities futures markets. These include wheat, corn, soybeans, and oils derived from some of these products, such as soybean oil and other vegetable oils.

These futures contracts must run out; they do not represent ownership in a stock, like owning a stock certificate does. True agricultural businessmen, such as farmers or agricultural exporters use commodity contracts to hedge the price fluctuations of their products. Speculators, however, take advantage of price movements, and are not interested in the buying or selling of the actual commodity.

On both the part of the farmer or the speculator, the “contract” may change hand several times before the actual delivery date of the commodity. But once the delivery date of the commodity becomes due, that commodity is “deliverable”. In the beginning of the commodities futures markets, people feared that they would have 5,000 bushels of wheat dumped on their lawn, but what actually happens is that the price difference between the winner (the one who guessed the correct direction of the price of wheat) and the loser, (the one who didn’t) would be settled by an exchange of money (the profit or loss on the contract).

Commodities that are traded in this way are not limited to wheat, corn and soybeans. The commodity market includes oil, precious metals and other commodities in addition to agricultural commodities. But they all got their start with the wheat traded in Chicago.

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